CHAPTER 9 Financial Planning and Forecasting Financial Statements 1
Topics in Chapter Financial planning Additional Funds Needed (AFN) formula Forecasted financial statements Sales forecasts Percent of sales method Ignore HW problem 9-6. 2
Financial Planning and Pro Forma Statements Three important uses: Forecast the amount of external financing that will be required Evaluate the impact that changes in the operating plan have on the value of the firm Set appropriate targets for compensation plans 3
Steps in Financial Forecasting Forecast sales Project the assets needed to support sales Project internally generated funds Project outside funds needed Decide how to raise funds See effects of plan on ratios and stock price 4
2009 Balance Sheet (Millions of $) Cash & sec. $ 20 Accts. pay. & Accounts rec. 240 accruals Notes payable $ 100 100 Inventories 240 Total CL $ 200 Total CA $ 500 L-T debt 100 Common stk 500 Net fixed assets 500 Retained earnings 200 Total assets $1,000 Total claims $1,000 5
2009 Income Statement (Millions of $) Sales $2,000.00 Less: COGS (60%) 1,200.00 SGA costs 700.00 EBIT $ 100.00 Interest 10.00 EBT $ 90.00 Taxes (40%) 36.00 Net income $ 54.00 Dividends (40%) $21.60 Add n to RE $32.40 6
AFN (Additional Funds Needed) Formula: Key Assumptions Operating at full capacity in 2009. Each type of asset grows proportionally with sales. Payables and accruals grow proportionally with sales. 2009 profit margin ($54/$2,000 = 2.70%) and payout (40%) will be maintained. Sales are expected to increase by $500 million. 7
Definitions of Variables in AFN A*/S 0 : assets required to support sales; called capital intensity ratio. 2009 data: 1,000/2,000 = 0.5 S: increase in sales. Projected: 500 millions L*/S 0 : spontaneous liabilities ratio 2009 data: 100/2,000 = 0.05 M: profit margin (Net income/sales) 2009 data: 54/2,000 = 0.027 RR: retention ratio; percent of net income not paid as dividend. 2009 data: 21.6/54 = 0.40 8
Assets vs. Sales 1,250 1,000 Assets Assets = 0.5 sales Assets = (A*/S 0 ) Sales = 0.5($500) = $250. 0 2,000 2,500 A*/S 0 = $1,000/$2,000 = 0.5 = $1,250/$2,500. Sales 9
If assets increase by $250 million, what is the AFN? AFN = (A*/S 0 ) S - (L*/S 0 ) S - M(S 1 )(RR) AFN = ($1,000/$2,000)($500) - ($100/$2,000)($500) - 0.0270($2,500)(1-0.4) AFN = $184.5 million. (Must be raised from external sources.) Big Assumption: None of the ratios change. 10
How would increases in these items affect the AFN? Higher sales: Increases asset requirements, increases AFN. Higher dividend payout ratio: Reduces funds available internally, increases AFN. (More ) 11
Higher profit margin: Increases funds available internally, decreases AFN. Higher capital intensity ratio, A*/S 0 : Increases asset requirements, increases AFN. Pay suppliers sooner: Decreases spontaneous liabilities, increases AFN. 12
Forecasted Financial Statements Method Relaxes the assumption that key ratios related to sales will remain constant Project sales based on forecasted growth rate in sales Forecast some items as a percent of the forecasted sales Costs Cash Accounts receivable (More...) 13
Items as percent of sales (Continued...) Inventories Net fixed assets Accounts payable and accruals Choose other items Debt Dividend policy (which determines retained earnings) Common stock 14
Sources of Financing Needed to Support Asset Requirements Given the previous assumptions and choices, we can estimate: Required assets to support sales Specified sources of financing Additional funds needed (AFN) is: Required assets minus specified sources of financing 15
Implications of AFN If AFN is positive, then you must secure additional financing. If AFN is negative, then you have more financing than is needed. Pay off debt. Buy back stock. Buy short-term investments. 16
How to Forecast Interest Expense Interest expense is actually based on the daily balance of debt during the year. There are three ways to approximate interest expense. Base it on: Debt at end of year Debt at beginning of year Average of beginning and ending debt More 17
Basing Interest Expense on Debt at End of Year Will over-estimate interest expense if debt is added throughout the year instead of all on January 1. Causes circularity called financial feedback: more debt causes more interest, which reduces net income, which reduces retained earnings, which causes more debt, etc. More 18
Basing Interest Expense on Debt at Beginning of Year Will under-estimate interest expense if debt is added throughout the year instead of all on December 31. But doesn t cause problem of circularity. More 19
Basing Interest Expense on Average of Beginning and Ending Debt Will accurately estimate the interest payments if debt is added smoothly throughout the year. But has problem of circularity. More 20
A Solution that Balances Accuracy and Complexity Base interest expense on beginning debt, but use a slightly higher interest rate. Easy to implement Reasonably accurate For examples that bases interest expense on average debt, see: Web Extension 9A.doc and IFM10 Ch09 WebA Tool Kit.xls IFM10 Ch09 Mini Case Feedback.xls 21
Percent of Sales: Inputs 2009 Actual 2010 Proj. COGS/Sales 60% 60% SGA/Sales 35% 35% Cash/Sales 1% 1% Acct. rec./sales 12% 12% Inv./Sales 12% 12% Net FA/Sales 25% 25% AP & accr./sales 5% 5% 22
Other Inputs Percent growth in sales 25% Growth factor in sales (g) 1.25 Interest rate on debt 10% Tax rate 40% Dividend payout rate 40% 23
2010 First-Pass Forecasted Income Statement Calculations 2010 1 st Pass Sales 1.25 Sales 09 = $2,500.0 Less: COGS 60% Sales 10 = 1,500.0 SGA 35% Sales 10 = 875.0 EBIT $125.0 Interest 0.1(Debt 09 ) = 20.0 EBT $105.0 Taxes (40%) 42.0 Net Income $63.0 Div. (40%) $25.2 Add to RE $37.8 24
2010 Balance Sheet (Assets) Calcuations 2010 Cash 1% Sales 10 = $25.0 Accts Rec. 12%Sales 10 = 300.0 Inventories 12%Sales 10 = 300.0 Total CA $625.0 Net FA 25% Sales 10 = 625.0 Total Assets $1,250.0 25
2010 Preliminary Balance Sheet (Claims) Calculations 2010 Without AFN AP/accruals 5% Sales 10 = $125.0 Notes payable 100 Carried over 100.0 Total CL $225.0 L-T debt 100 Carried over 100.0 Common stk 500 Carried over 500.0 Ret earnings 200 +37.8* 237.8 Total claims $1,062.8 26
What are the additional funds needed (AFN)? Required assets = $1,250.0 Specified sources of fin. = $1,062.8 Forecast AFN: $1,250 - $1,062.8 = $187.2 NWC must have the assets to make forecasted sales, and so it needs an equal amount of financing. So, we must secure another $187.2 of financing. 27
Assumptions about how AFN will be raised No new common stock will be issued. Any external funds needed will be raised as debt, 50% notes payable, and 50% L-T debt. 28
How will the AFN be financed? Additional notes payable =0.5 ($187.2) = $93.6. Additional L-T debt = 0.5 ($187.2) = $93.6. 29
2010 Balance Sheet (Claims) w/o AFN AFN With AFN AP accruals $125.0 $125.0 Notes payable 100.0 +93.6 193.6 Total CL $225.0 $318.6 L-T Debt 100.0 +93.6 193.6 Common stk 500.0 500.0 Ret earnings 237.8 237.8 Total claims $1,071.0 $1250.0 30
Equation AFN = $184.5 vs. Pro Forma AFN = $187.2. Equation method assumes a constant profit margin. Pro forma method is more flexible. More important, it allows different items to grow at different rates. STOP HERE FOR EXAM 2! 31
Forecasted Ratios 2009 2010(E) Industry Profit Margin 2.70% 2.52% 4.00% ROE 7.71% 8.54% 15.60% DSO (days) 43.80 43.80 32.00 Inv turnover 8.33 8.33 11.00 FA turnover 4.00 4.00 5.00 Debt ratio 30.00% 40.98% 36.00% TIE 10.00 6.25 9.40 Current ratio 2.50 1.96 3.00 32
What are the forecasted free cash flow and ROIC? Net operating WC (CA - AP & accruals) Total operating capital (Net op. WC + net FA) 2009 2010(E) $400 $500 $900 $1,125 NOPAT (EBITx(1-T)) Less Inv. in op. capital $60 $75 $225 Free cash flow -$150 ROIC (NOPAT/Capital) 6.7% 33
Proposed Improvements Before After DSO (days) 43.80 32.00 Accts. rec./sales 12.00% 8.77% Inventory turnover 8.33 11.00 Inventory/Sales 12.00% 9.09% SGA/Sales 35.00% 33.00% 34
Impact of Improvements (see IFM10 Ch09 Mini Case.xls for details) Before After AF $187.2 $15.7 Free cash flow -$150.0 $33.5 ROIC (NOPAT/Capital) 6.7% 10.8% ROE 7.7% 12.3% 35
If 2009 fixed assets had been operated at 75% of capacity: Capacity sales = Actual sales % of capacity $2,000 = = $2,667. 0.75 With the existing fixed assets, sales could be $2,667. Since sales are forecasted at only $2,500, no new fixed assets are needed. 36
How would the excess capacity situation affect the 2010 AFN? The previously projected increase in fixed assets was $125. Since no new fixed assets will be needed, AFN will fall by $125, to: $187.2 - $125 = $62.2. 37
Economies of Scale 1,100 1,000 Assets } Base Stock Declining A/S Ratio 0 2,000 2,500 Sales $1,000/$2,000 = 0.5; $1,100/$2,500 = 0.44. Declining ratio shows economies of scale. Going from S = $0 to S = $2,000 requires $1,000 of assets. Next $500 of sales requires only $100 of assets. 38
Lumpy Assets 1,500 Assets 1,000 500 500 1,000 2,000 Sales A/S changes if assets are lumpy. Generally will have excess capacity, but eventually a small S leads to a large A. 39
Summary: How different factors affect the AFN forecast. Excess capacity: lowers AFN. Economies of scale: leads to less-thanproportional asset increases. Lumpy assets: leads to large periodic AFN requirements, recurring excess capacity. 40